Over the last three decades, there is rapid growth in international equity investments. The increasing trend in equity investment has lead to increase in high demand and supply of foreign currencies. The high demand of currencies and equity flows has created some interdependence between equity returns and exchange rate returns. The increasing interdependency has also increased the volatility transmission betweens stock and foreign exchange market that has increased the international portfolio risk that is faced by investors, which has further lead to decrease the returns of investors portfolios (Kanas 2000). According to (Ebrahim 2000), it is important to know about how shocks are transmitted across financial markets (stock and currency market) and also to explore the magnitude of their effects. This will further enhance the success of policies implemented by policy makers.
The theoretical consensus regarding the linkages between stock prices and exchange rates can be derived from two widely used models named as; flow oriented model (Dornbusch & Fischer, 1980) and stock oriented model (Branson and Henderson 1985; Frankel 1983). The flow oriented model (Dornbusch and Fischer 1980) posits that positive relationship exist between exchange rates and stock prices. This model is based on the idea that exchange rate is determined by a country’s current account balance or trade balance. This model assumes that changes in the foreign exchange rate can effect trade balances and international competitiveness. Therefore, affect the real income and inputs. The phenomena can be explained as; the local currency depreciationFootnote 1 will make domestic firms more competitive by having cheaper exports in international trade. The higher exports will enhance the domestic wealth of firms by appreciating the domestic stock prices of domestic firms. In this aspect, causality will run from exchange rate to stock price.
The stock oriented model (Branson and Henderson 1985; Frankel 1983) suggests that the exchange rate is determined by supply and demand of financial assets (equity and bonds). This model is further classified into portfolio balance model and monetary model. The portfolio balance model posits that negative relationship exist between stock prices and exchange rates. This model suggests that causality runs from stock prices to exchange rates. According to this model, investors hold foreign and domestic assets including domestic and foreign currencies. When domestic assets stock prices increases, so investors intends to buy more domestic assets, which compel them to sell their foreign assets in order to have more domestic currency in hand for the purpose of buying more domestic assets. The increase in wealth of investors due to increase in domestic assets prices motivates them to demand for more domestic assets which in turns leads to increase in interest rates. This will lead to currency appreciation.Footnote 2 The monetary approach however postulates weaker or no relationship of exchange rates and stock prices. In this model, exchange rate is considered to be the price of an asset. As prices of assets are based on future expected prices, similarly exchange rates are also determined by future expected exchange rates. So any factor that changes the expected future value of exchange rate will affect today’s value of exchange rate. The factors that cause changes in exchange rates may differ from those factors that brought changes in stock prices. Hence, in such conditions there may be no relationship between stock prices and exchange rates.Footnote 3
The information spillover between the two financial markets (foreign exchange market and stock market) has been studied by many researchers for different countries. Most of the studies have focused on the transmission of volatility between foreign exchange market and stock market. The developed countries have been extensively studied by most of researchers (see for example; Antonakakis 2012; Apergis and Rezitis 2001; Beer and Hebein 2011; Ebrahim 2000; Francis et al. 2006; Grobys 2015; Kanas 2000; Yang and Doong 2004). There are also number of studies of integration of foreign exchange market and stock market of developing countries (for example; Choi et al. 2010; Kang and Yoon 2013; Mishra et al. 2007; Morales 2008; O’Donnell and Morales 2009; Qayyum and Kamal 2006; Yang and Chang 2008). There are also some studies for emerging countries for instance (see, for examples; Adjasi et al. 2008; Fedorova and Saleem 2009; Li and Majerowska 2008; Oberholzer and Boetticher 2015; Okpara and Odionye 2012; Walid et al. 2011).
This study intends to investigate the asymmetric volatility spillover dynamics of stock and foreign exchange market using EGARCH model in Asian countries. One of the rationale behind selection of Asian countries sample is that the literature doesn’t provide enough evidence in the specific area. This study aimed to consider a sample of developed and emerging markets of Asia. The Asian countries included in this study are; China, India, Hong Kong, Japan, Pakistan and Sri Lanka. The sample constitutes developed country of Japan and markets of China, India, Hong Kong Pakistan and Sri Lanka. The sample also represents three countries from South Asia i.e. Sri Lanka, India and Pakistan; and three countries from East Asia i.e. Japan, Hong Kong and China. The contribution of the study will be in the following aspects. First, instead of analyzing a single country, this study investigates volatility spillover between stock market and foreign exchange market in sample of different Asian countries. Second, this study will add some valuable knowledge to existing literature in terms of selected Asian countries sample. In reference to Pakistan; we only found a single study of Qayyum and Kamal (2006) that employed weekly data covering the period from 1998 to 2006. The contribution of this study in reference to Pakistan is as follow. First, we have used daily data instead of weekly because stock and foreign exchange market trading occurs on daily basis and the shock that arises on daily basis is absorbed in weekly data. Second, we have used data set covering the period from 1999 to 2014. In reference to Sri Lanka, up to best of our knowledge, this study is the first to address volatility spillover between stock market and foreign exchange market. In this aspect, this study will be a novel contribution in reference to Sri Lanka. In context of China, Hong Kong, India and Japan, we have found many studies but with mixture of results like (Chkili 2012) and (Beer and Hebein 2011) reported contrasting results in case of Hong Kong. Similarly, (Mishra et al. 2007) and (Beer and Hebein, 2011) found different results for India. (Kanas 2000; Yang and Doong 2004) and (Beer and Hebein 2011; Francis et al. 2006) found contrasting results for Japan. Therefore there is still a gap to explore knowledge about the volatility spillover dynamics in the selected countries. The other contribution of this study is considering daily data covering period of 15 years in order to examine volatility spillover in long run. The reason behind selection of daily data is to capture more information that we can do in weekly and monthly data. Furthermore, the results of this study will be important for economic policy makers, investors and multinational firms. The policy makers will benefit from this study by knowing the behavior of two markets in order to implement policies for financial stability perspective. Investors will use the information to manage their international portfolio risk and currency risk strategies. This study is also important for multinational firms which intend to manage their international currency exposures.
The remainder of the paper is organized as follows. The second section presents the literature. The third section presents the methods. The fourth section shows the results and discussion. The fifth section presents the conclusions and policy implication.
Review of literature
There are numerous studies that investigated the volatility transmission mechanism between stock and foreign exchange market. The literature can be divided into three aspects; First, those studies that reveals bidirectional volatility spillover between the two markets; Second, those studies which found unidirectional flow of volatility either from stock to foreign exchange market or from foreign exchange market to stock market; Third, those studies which reported no volatility spillover between the two markets. The bidirectional flow of volatility between the two financial markets has been reported by following studies, see (Aloui 2007; Andreou et al. 2013; Chkili 2012; Choi et al. 2010; Francis et al. 2006; Mishra et al. 2007; Qayyum and Kamal 2006; Xiong and Han 2015). Francis et al. (2006) examined US with Germany, Japan, UK and Canada. They observed bidirectional volatility spillover between currency and equity market for German and US countries. The transmission of volatility between the two markets has been found asymmetric in nature. In other study, Aloui (2007) examined US equity and currency market along with 5 major European countries. The analyses were carried out on EGARCH model that confirms bidirectional volatility spillover between equity and currency market. They concluded that persistence of the stock prices volatility was more than exchange rate. Qayyum and Kamal (2006) examined the volatility spillover effects of the two financial markets for Pakistan. They concluded statistically significant bidirectional transmission mechanism of stock returns and exchange rate returns. Mishra et al. (2007) empirically investigated the volatility dynamic effects between the two markets with reference to India. Their analyses show clear evidence of bidirectional flow of shocks between the currency and equity market. Recently, similar results have been reported by (Kumar 2013; Panda and Deo 2014) for India. Choi et al. (2010) empirically investigated the New Zealand currency and equity market for volatility transmission mechanism. They concluded bidirectional mechanism of volatility for the two financial markets. Chkili (2012) investigated 8 emerging markets i.e. Argentina, Brazil, Hong Kong, Malaysia, Singapore, Mexico, Indonesia and South Korea by using BEKK-MGARCH model. Their analyses reveal bidirectional shock spillover between two financial markets in most cases. Andreou et al. (2013) analyzed 12 emerging markets including six from Asia and six from Latin America. The analyses reveal bidirectional volatility spillover between equity and currency market. Recently, Xiong and Han (2015) reported bidirectional volatility spillover between the two markets for China.
The unidirectional transmission of volatility between equity and currency market has been reported by following studies (Adjasi et al. 2008; Antonakakis 2012; Beer and Hebein 2011; Chkili and Nguyen 2014; Ebrahim 2000; Fedorova and Saleem 2009; Kanas 2000; Kang and Yoon 2013; O’Donnell and Morales 2009; Okpara and Odionye 2012; Yang and Doong 2004; Yang and Chang 2008). Ebrahim (2000) empirically examined the flow of volatility of exchange rate on the developed equity markets. The empirical evidence show asymmetric unidirectional price spillover for all the selected models. Kanas (2000) made an attempt to explore the developed equity countries i.e. France, Germany, US, Japan, Canada and UK for transmission of volatility between the two markets. He found significant unidirectional volatility effects flowing from equity returns to exchange rate returns for all economies except Germany. In other study, Yang and Doong (2004) extended the literature for G7 countries for currency and equity market spillover effects. Their results show evidence of unidirectional transmission of shocks from equity to exchange rate market for United States, France, Italy and Japan. O’Donnell and Morales (2009) investigated Hungary, Slovakia, Czech republic and Poland. In case of Czech Republic and Slovakia, they reported unidirectional flow of volatility from currency rates to equity prices. Adjasi et al. (2008) empirically investigated Ghanaian stock and currency market and found significant spillover from currency returns to equity returns. Beer and Hebein (2011) made an attempt on studying the G8 countries with South Korea, Hong Kong, India and Philippines. The unidirectional shock flow has been observed from currency market to equity market for Japan, India, US, Korea and Canada only. Yang and Chang (2008) carried out a study on Taiwan, South Korea, Japan, Singapore and USA and reported unidirectional asymmetric shock spillover from equity to currency market. Fedorova and Saleem (2009) examined the shock spillover of currency with equity market in European countries. Their empirical evidences showed currency spillover to equity market for all countries except Czech Republic. Okpara and Odionye (2012) empirically found unidirectional transmission of shocks from exchange rate to equity market for Nigeria. Antonakakis (2012) examined cross border currency shock spillover before and after Euro and other currency including Japanese yen, Swiss France and British Pound. They found evidence of cross border shock spillover for all currencies. Kang and Yoon (2013) reported unidirectional flow from exchange rate market to equity market of volatility with reference to Korea. Chkili and Nguyen (2014) recently examined the BRICS countries i.e. Brazil, Russia, India, China and South Africa. They used regime switching model and found volatility spillover from stock prices to exchange rate with no feedback from exchange rate.
In contrast to empirical evidences discussed in above literature, there are also studies that reported no evidence of flow of volatility between stock market and foreign exchange market, see (Apergis and Rezitis 2001; Kearney and Daly 1998; Morales 2008). Apergis and Rezitis (2001) extended the literature for New York and London and found no evidence of volatility transmission between currency and stock market. Morales (2008) empirically studied Six Latin American countries; Venezuela, Argentina, Mexico, Brazil, Colombia and Spain with a European country and found no clear evidence of flow of volatility between the two financial markets. Kearney and Daly (1998) tested the stated relationship for Australia and found no evidence of volatility flow between currency market and stock market.